Cape Verde—Letter of Intent, Supplementary Memorandum of Economic and Financial Policies


December 6, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
U.S.A.

On April 4, 2002, the Executive Board of the IMF approved a three-year arrangement for Cape Verde under the Poverty Reduction and Growth Facility (PRGF) in the amount of SDR 8.64 (90 percent of quota). The purpose of this letter is to inform you of the progress in implementing the first-year economic program, and to request the second loan disbursement upon completion of the first review under the arrangement.

The attached memorandum of economic and financial policies (MEFP) supplements the MEFP of March 11, 2002, and sets out the objectives and policies the government of Cape Verde is pursuing during the remainder of 2002 and the first half of 2003.

Cape Verde's economic performance in 2002 has been generally better than envisaged under the program, despite the adverse effects of the global economic slowdown and the impact of the events of September 11, 2001. Macroeconomic policies have been restrained, and progress has been made in key structural areas. The government believes that the policies it intends to pursue in the period through June 2003, as described in the attached MEFP, will build on this favorable performance and establish the conditions for achieving a high level of sustainable economic growth and a reduction in poverty. On this basis, the government requests the completion of the first review under the arrangement and waivers for the nonobservance of the end-June 2002 performance criteria pertaining to nonconcessional debt, the accumulation of domestic arrears, and the implementation of an automatic retail pricing mechanism for petroleum products.

The government believes that the measures and policies set forth in the attached memorandum are adequate to achieve its program objectives, but it will take any further action that may prove necessary for this purpose. For as long as Cape Verde has outstanding financial obligations to the Fund arising from the loans under the arrangement, the government will consult with the Fund, at the initiative of the government or whenever the Managing Director requests consultation, on Cape Verde's economic and financial policies.

The government authorizes the Fund to provide this letter, the attached memorandum, and the associated staff report to all interested parties that request them, including through the Fund's external website.

Sincerely yours,

Cape Verde
Supplementary Memorandum of Economic and Financial Policies for September 2002–June 2003

I. Introduction

1. Cape Verde's ongoing medium-term economic program is being supported by a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF). Consistent with the goals set out in our memorandum on economic and financial policies dated March 11, 2002, this supplementary memorandum reviews the implementation of the program so far in 2002 and sets forth our policies for the remainder of the first program year through June 2003.

II. Performance Under the PRGF-Supported Program

2. Economic performance in 2002 has been better than envisaged under the program: (i) the inflation rate is lower; (ii) real economic growth is higher; (iii) the fiscal deficit is smaller; and (iv) the balance of payments is stronger. Exports, tourism receipts, and private transfers performed better than expected, and strong imports of capital and intermediate goods indicate the beginning of a rebound in investment. Based on this and other information, real economic growth in 2002 will be on the order of 4-5 percent, against the 2.5 percent projected earlier. The inflation rate was -0.6 percent for the 12 months ended September, and on this basis the inflation rate should average about 1.7 percent for the year as a whole, against the 3.0 percent envisaged in the MEFP dated March 11, 2002.

3. Macroeconomic policy has been generally on track, the nonobservance of two quantitative and one structural performance criteria notwithstanding (Appendix I, Table 1). The government signed a US$2.5 million nonconcessional loan agreement in January 2002 to finance a road construction project that had been contracted in 2000. A bilateral donor is paying the interest on the loan, thereby bringing the grant element of the loan to about 18 percent. We are seeking additional assistance with regard to principal repayments to bring the grant element to at least 35 percent. The government accumulated arrears to the recently privatized power company, which had been accumulating tax and debt-service liabilities to the government. The government has cleared all the arrears it incurred this year to the power company and will henceforth pay all its domestic bills when due.

4. The fiscal outcome has been better than programmed, reflecting stronger revenue performance across all categories and the restraint of recurrent expenditures. Outlays for capital projects have been higher than programmed, owing to a more rapid pace of donor disbursements than projected. The government's commitment to clear all domestic arrears as quickly as possible required a higher level of access to domestic bank financing than envisaged, but domestic financing of the budget is the same as programmed. The rescheduling of external payment arrears has helped to reestablish foreign credit lines and increase the pace of implementing the public investment program.

5. Monetary policy continues to be oriented toward sustaining the exchange rate peg, which has been the key to Cape Verde's price stability. Broad money increased by 17 percent during the 12 months ended September 2002, primarily because of the strong balance of payments, but also because of an increase in commercial bank credit to government used to clear domestic arrears. The overall balance of payments registered a surplus of EUR 18 million through September, compared with a programmed surplus of EUR 2.5 million for the year as a whole. This reflects the stronger-than-expected performance of exports, tourism receipts, private and official transfers, and private capital flows. Against the background of the continued tight fiscal policy, strong balance of payments, and low inflation rates, the Bank of Cape Verde (BCV) lowered its refinancing rate in May, leading to a subsequent small decline in commercial lending and deposit rates in June; nonetheless, these rates remain high in real terms.

6. Progress on the structural front has been mixed, but the government is taking measures to address the slippages that have occurred so far. The key measures are noted below, and the status of other structural measures is indicated in Table 3:

• The new organic central bank law was unanimously approved ahead of schedule by the National Assembly. The new law clearly establishes the independence of the Bank of Cape Verde and prohibits the extension of central bank credit to the government, except for a temporary overdraft facility that must be cleared at the end of each year.
  
  
• The structural performance criterion pertaining to the implementation of an automatic and transparent pricing mechanism for retail petroleum products was not met. This issue proved to be technically more complex than initially thought, and negotiations with the oil companies have taken longer than expected. However, the Council of Ministers approved the mechanism in August 2002 and announced that it would become effective on January 1, 2003. This will be a performance criterion under the second PRGF review.
  
  
• The National Assembly unanimously approved the new value-added tax (VAT) law and a new customs tariff schedule in June. The government will submit all necessary supporting regulations to the National Assembly for approval before the end of this year and implement the new tax package by June 1, 2003, as indicated in the 2003 budget.
  
  
• The government is liquidating two large loss-making public enterprises: EMPA (food import and distribution) and TRANSCOR (municipal transport). The fiscal impact of the attendant retrenchment costs is substantial but manageable. The government is seeking additional donor assistance in this area.

7. The government completed the National Development Plan for 2002-05, which forms the foundation of our poverty reduction strategy paper (PRSP). High rates of real economic growth will be necessary to significantly reduce poverty in Cape Verde, and we have been exploring the possibilities of achieving sustained rates of economic growth in the range of 5-6 percent. The recent completion of the household income and expenditure survey, and of the public expenditure reviews, will enable the government to strengthen its analysis of the relationship between economic growth and poverty reduction in Cape Verde. The government will review the 2003 work plan of the National Institute of Statistics, with a view to clarifying its priorities to ensure that key economic indicators are collected and disseminated in a timely manner. The government is preparing a PRSP preparation status report and expects to complete Cape Verde's full PRSP by May-June 2003.

III. Macroeconomic Framework and Policies for September 2002–June 2003

8. The government believes that the strategy and policies supported by the PRGF arrangement remain appropriate. A number of factors indicate that real economic growth in 2003 could be higher than the 3.5 percent projected in the medium-term framework underpinning the PRGF:

• a continued implementation of fiscal restraint, which will reduce the government's domestic borrowing needs and strengthen investor confidence;
• gradual lowering of domestic interest rates to help support private sector investment without endangering the balance of payments;
• an improved domestic business environment realized through structural reforms, including tax and regulatory reform;
• the upturn in world economic activity;
• the opening of key Cape Verde tourist destinations to foreign investors;
• access to U.S. textile markets under the African Growth and Opportunity Act;
• the expected lifting of the European Union embargo on Cape Verde's seafood products; and
• more rapid implementation of the government's public investment program, now that arrears have been regularized with our development partners.

9. Against this background, the government's draft 2003 budget projects real economic growth in the range of 5-6 percent and an inflation rate of 2-2.5 percent. The external position is expected to improve moderately, with the external current account deficit (excluding official transfers) in the range of 13-14 percent of GDP and an increase in international reserves to about 1.8-2.0 months of imports of goods and nonfactor services. In addition to completing the reforms that had been envisaged for 2002, the government will take additional measures to ensure the sustainability of high levels of economic growth and a reduction in the incidence of poverty.

A. Fiscal Policy

10. The overall fiscal deficit for 2002 is being limited to CVEsc 1.41 billion, somewhat smaller than targeted. Revenues are performing better than expected across all categories, especially taxes on imports, and conditions for the disbursement of all programmed budget support have been met. Capital expenditure will be higher than projected because improved implementation of the public investment program will lead to quicker disbursements of donor support.

11. The fiscal program for 2003 reaffirms the government's commitment to providing an expanding the level of key social services, develop Cape Verde's infrastructure, and foster private-sector-led economic growth, while maintaining overall fiscal discipline. Continued fiscal consolidation will support the BCV's policy of pursuing lower interest rates in the context of a sustainable balance of payments. Revenue (including domestic capital participation and net lending) is projected to remain in the range of 23-24 percent of GDP. Total expenditure will be in the range of 31½ percent of GDP. The government will continue to run a sizable primary recurrent surplus in the context of increased outlays for health, education, and security.

12. The government's total external financing requirement (grants plus loans) will be on the order of EUR 80 million for 2003, including about EUR 27 million in budget support, in order to help support the government's poverty reduction strategy and to defray some one-off expenditures, including substantial outlays for retrenchment costs. The government will convene a roundtable conference early in 2003 to help secure financing and to inform donors of its progress in preparing Cape Verde's full PRSP. In the meantime, the economic program is fully financed for the first half of 2003. To help ensure that domestic debt falls to a sustainable level, we will also be seeking donor assistance to restart the domestic debt-reduction operation (DDRO).

13. With regard to tax reform, the government will focus its efforts on ensuring that the VAT and new customs tariff structure are fully implemented by June 2003. The government is also proposing to reduce the corporate income tax rate from 35 percent to 30 percent. This will not have an impact until 2004, as these taxes are paid on the previous year's income. The government inherited a large number of customs and tax exemptions, that undermine its objectives of exercising fiscal restraint and providing more resources for antipoverty programs. While the government continues to support certain exemptions in high-priority sectors and for diplomatic missions in Cape Verde, a preliminary review of customs and consumption tax exemptions estimates that the revenue loss from these alone will amount to nearly CVEsc 2.5 billion (3.5 percent of GDP) in 2002. In addition, income tax holidays are granted via a number of different laws. As a first step to address these revenue losses, all consumption tax exemptions will be eliminated with the introduction of the VAT, and no new exemptions will be granted in the 2003 budget. Meanwhile, the government will seek technical assistance to undertake a comprehensive and thorough review of the impact of all tax exemptions, with a view to further reducing their number.

14. The government intends to strengthen the budget process and expenditure control and will appoint an externally financed budget advisor before March 2003. Sector specialists within the Ministry of Finance have been appointed to review spending agencies' budget submissions and ensure that their budget proposals are consistent with the government's overall public expenditure program. Technical assistance will be sought to help revise our organic budget law.

B. Monetary and Financial Sector Policies

15. Monetary policy will be oriented toward price stability and the continued strengthening of international reserves in the context of a gradual lowering of domestic interest rates. Continued fiscal restraint will be a key component of this strategy. Broad money growth is expected to fall to about 13 percent by the end of this year and to a range of 7-9 percent in the coming year, in line with nominal GDP. Growth in credit to the economy is projected to expand on the order of 12-14 percent. The rapid growth in broad money through September 2002 may result in a one-off decline in international reserves in the coming months, but net international reserves are still projected to increase for 2002 as a whole.

16. The BCV is implementing a number of projects to strengthen its operational and oversight responsibilities. The BCV will continue to strengthen banking supervision through the training of staff, in cooperation with partners in other countries, by increasing the number of on-site examinations, modernizing the off-site reporting system, and strengthening its supervision of offshore financial institutions. The National Assembly has approved the first reading of the new anti-money-laundering law and is expected to approve it before the end of the year. The BCV will also continue to license qualified banks and other financial institutions in order to increase competition and promote the development of a competitive financial sector. The BCV is also working closely with the National Institute of Statistics to develop monthly indicators of economic and financial activity. It is also seeking additional technical assistance to improve balance of payments statistics and the implementation of monetary policy in a fixed exchange rate regime.

C. External Sector Policies and Competitiveness

17. Private-sector-led economic growth is a crucial component of Cape Verde's poverty reduction strategy and external viability. It is the government's objective to promote exports, especially of manufactured goods, tourism, and transportation services, and to attract a higher level of foreign direct investment and other private capital inflows. This strategy will require a dynamic private sector that is able to compete effectively in world markets, and structural reforms, human development, legal reforms, and investment promotion will all be necessary to achieve these objectives. To this end, the government's public investment program will continue to focus on improving basic infrastructure (roads, water, power, and telecommunications). In addition, the government will focus recurrent expenditures on education, health, and basic social services. The government is reviewing the country's labor laws, with a view to removing barriers to employment, and it is also working to eliminate administrative barriers to foreign and domestic investment. Many of these issues will be addressed in the context of the government's growth and competitiveness project, for which donor assistance is being sought.

IV. Program Monitoring

18. Program implementation through June 2003 will be monitored according to the performance criteria and benchmarks presented in Appendix I, Tables 1 and 2. Table 3 describes the government's broader economic reform objectives for 2002 and notes their status of implementation. The definition of the variables monitored as quantitative performance criteria and benchmarks and reporting requirements remain as set forth in the technical memorandum of understanding (EBS/02/54, Appendix I, Attachment II). The second review will be conducted by April 30, 2003.